Financial Accounting: Tools for Business Decision Making
Eighth Edition
Kimmel ● Weygandt ● Kieso
Chapter 10
Reporting and Analyzing Liabilities
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Financial Accounting: Tools for Business Decision Making
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Copyright ©2017 John Wiley & Sons, Inc.
Chapter Outline:
Learning Objectives
Explain how to account for current liabilities.
Describe the major characteristics of bonds.
Explain how to account for bond transactions.
Discuss how liabilities are reported and analyzed.
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L O 1: Explain How to Account for Current Liabilities
What is a Current Liability?
A debt that a company expects to pay
from existing current assets or through the creation of other current liabilities, and
within one year or the operating cycle, whichever is longer.
Current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest.
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What Is a Current Liability? (1 of 2)
Review Question
To be classified as a current liability, a debt must be expected to be paid within:
a. 1 year.
b. the operating cycle.
c. 2 years.
d. (a) or (b), whichever is longer.
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What Is a Current Liability? (2 of 2)
Review Question
To be classified as a current liability, a debt must be expected to be paid within:
a. 1 year.
b. the operating cycle.
c. 2 years.
d. (a) or (b), whichever is longer.
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Notes Payable (1 of 4)
Written promissory note.
Usually require the borrower to pay interest.
Frequently issued to meet short-term financing needs.
Issued for varying periods of time.
Those due for payment within one year of the balance sheet date are usually classified as current liabilities.
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Notes Payable (2 of 4)
Illustration: First National Bank agrees to lend $100,000 on September 1, 2017, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1. When a company issues an interest-bearing note, the amount of assets it receives generally equals the note’s face value.
Sept. 1
Cash
100,000
Notes Payable
100,000
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Notes Payable (3 of 4)
Illustration: If Cole Williams Co. prepares financial statements annually, it makes an adjusting entry at December 31 to recognize interest.
Dec. 31
Interest Expense
4,000 *
Interest Payable
4,000
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Notes Payable (4 of 4)
Illustration: At maturity (January 1), Cole Williams Co. must pay the face value of the note plus interest. It records payment as follows.
Jan. 1
Notes Payable
100,000
Interest Payable
4,000
Cash
104,000
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Sales Taxes Payable (1 of 3)
Sales taxes are expressed as a stated percentage of the sales price.
Selling company
collects tax from the customer.
remits the collections to the state’s department of revenue.
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Sales Taxes Payable (2 of 3)
Illustration: The March 25 cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is:
Mar. 25
Cash
10,600
Sales Revenue
10,000
Sales Taxes Payable
600
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Sales Taxes Payable (3 of 3)
Sometimes companies do not ring up sales taxes separately on the cash register.
Illustration: Cooley Grocery rings up total receipts of $10,600. Because the amount received from the sale is equal to the sales price 100% plus 6% of sales, (sales tax rate of 6%), the journal entry is:
Mar. 25
Cash
10,600
Sales Revenue
10,000 *
Sales Taxes Payable
600
* $10,600 ÷ 1.06 = $10,000
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Unearned Revenues (1 of 2)
Revenues that are received before goods are delivered or services are performed.
Company increases (debits) Cash and increases (credits) a current liability account, Unearned Revenue.
When the company recognizes revenue, it decreases (debits) the unearned revenue account and increases (credits) a revenue account.
Type of Business
Airline
Magazine publisher
Hotel
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Unearned Revenues (2 of 2)
Illustration: Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. The entry for the sales of season tickets is:
Aug. 6
Cash
500,000
Unearned Ticket Revenue
500,000
As each game is completed, Superior records the earning of revenue.
Sept. 7
Unearned Ticket Revenue
100,000
Ticket Revenue
100,000
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Current Maturities of long-term Debt
Portion of long-term debt that comes due in the current year.
No adjusting entry required.
Illustration: Wendy Construction issues a five-year, interest-bearing $25,000 note on January 1, 2016. This note specifies that each January 1, starting January 1, 2017, Wendy should pay $5,000 of the note. When the company prepares financial statements on December 31, 2016,
What amount should be reported as a current liability?
$5,000
What amount should be reported as a long-term liability?
$20,000
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Do It! 1: Current Liabilities
You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.
If cash is borrowed on a $50,000, 6-month, 12% note on September 1, how much interest expense would be incurred by December 31?
The cash register total including sales taxes is $23,320, and the sales tax rate is 6%. What is the sales taxes payable?
$23,320 ÷ 1.06 = $22,000; $23,320 − $22,000 = $1,320
If $15,000 is collected in advance on November 1 for 3 months’ rent, what amount of rent revenue should be recognized by December 31?
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Payroll and Payroll Taxes Payable (1 of 4)
The term “payroll” pertains to both:
Salaries - managerial, administrative, and sales personnel (monthly or yearly rate).
Wages - store clerks, factory employees, and manual laborers (rate per hour).
Determining the payroll involves computing three amounts: (1) gross earnings, (2) payroll deductions, and (3) net pay.
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Payroll and Payroll Taxes Payable (2 of 4)
Illustration: Assume Cargo Corporation records its payroll for the week of March 7 as follows:
Mar. 7
Salaries and Wages Expense
100,000
F I C A Taxes Payable
7,650
Federal Income Taxes Payable
21,864
State Income Taxes Payable
2,922
Salaries and Wages Payable
67,564
Record the payment of this payroll on March 7.
Mar. 7
Salaries and Wages Payable
67,564
Cash
67,564
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Payroll and Payroll Taxes Payable (3 of 4)
Payroll tax expense results from three taxes that governmental agencies levy on employers.
These taxes are:
F I C A tax
Federal unemployment tax
State unemployment tax
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Payroll and Payroll Taxes Payable (4 of 4)
Illustration: Based on Cargo Corp.’s $100,000 payroll, the company would record the employer’s expense and liability for these payroll taxes as follows.
Payroll Tax Expense 13,850 Blank
F I C A Taxes Payable Blank 7,650
Federal Unemployment Taxes Payable Blank 800
State Unemployment Taxes Payable Blank 5,400
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Payroll Taxes (1 of 2)
Review Question
Employer payroll taxes do not include:
a. federal unemployment taxes.
b. state unemployment taxes.
c. federal income taxes.
d. F I C A taxes.
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Payroll Taxes (2 of 2)
Review Question
Employer payroll taxes do not include:
a. federal unemployment taxes.
b. state unemployment taxes.
c. federal income taxes.
d. F I C A taxes.
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Anatomy of a Fraud
Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fill in when regular custodians were absent. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district office, and personally distributed the checks to the “employees.” If a substitute’s check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000.
Total take: $150,000
The Missing Controls
Human resource controls. Thorough background checks should be performed. No employees should begin work until they have been approved by the Board of Education and entered into the payroll system. No employees should be entered into the payroll system until they have been approved by a supervisor. All paychecks should be distributed directly to employees at the official school locations by designated employees or direct-deposited into approved employee bank accounts.
Independent internal verification. Budgets should be reviewed monthly to identify situations where actual costs significantly exceed budgeted amounts.
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Do It! 1b: Wages and Payroll Taxes (1 of 2)
During the month of September, Lake Corporation’s employees earned wages of $60,000. Withholdings related to these wages were $3,500 for Social Security (F I C A), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state. Prepare the September 30 journal entries for (a) salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October, and (b) the company’s payroll tax expense.
Sep. 30
Salaries and Wages Expense
60,000
FICA Taxes Payable
3,500
Federal Income Taxes Payable
6,500
State Income Taxes Payable
2,000
Salaries and Wages Payable
48,000
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Do It! 1b: Wages and Payroll Taxes (2 of 2)
During the month of September, Lake Corporation’s employees earned wages of $60,000. Withholdings related to these wages were $3,500 for Social Security (F I C A), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state. Prepare the September 30 journal entries for (a) salaries and wages expense and salaries and wages payable, assuming that all September wages will be paid in October, and (b) the company’s payroll tax expense.
Sep. 30
Payroll Tax Expense
3,740
FICA Taxes Payable
3,500
Federal Unemployment Taxes Payable
90
State Unemployment Taxes Payable
150
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L O 2: Describe the Major Characteristics of Bonds
Bonds are a form of interest-bearing notes payable issued by corporations, universities, and governmental agencies.
Sold in small denominations (usually $1,000 or multiples of $1,000).
When a corporation issues bonds, it is borrowing money. The person who buys the bonds (the bondholder) is investing in bonds.
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Types of Bonds (1 of 2)
Secured and Unsecured Bonds
Secured bonds have specific assets of the issuer pledged as collateral for the bonds.
Unsecured bonds are issued against the general credit of the borrower.
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Types of Bonds (2 of 2)
Convertible and Callable Bonds
Convertible bonds can be converted into common stock at the bondholder’s option.
Callable bonds can be redeemed (bought back), by the issuing company, at a stated dollar amount prior to maturity.
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Issuing Procedures (1 of 2)
Bond certificate
Issued to the investor.
Provides name of the company issuing bonds, face value, maturity date, and contractual (stated) interest rate.
Face value - principal due at the maturity.
Maturity date - date final payment is due.
Contractual interest rate – rate to determine cash interest paid, contractual rate is stated as an annual rate.
Alternative Terminology
The contractual rate is often referred to as the stated rate.
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Issuing Procedures (2 of 2)
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Determining the Market Price of Bonds
The current market price (present value) of a bond is a function of three factors:
the dollar amounts to be received,
the length of time until the amounts are received, and
the market rate of interest.
The process of finding the present value is referred to as discounting the future amounts.
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Determining the Market Value
Illustration: Assume that Acropolis Company on January 1, 2017, issues $100,000 of 9% bonds, due in five years, with interest payable annually at year-end.
Present value of $100,000 received in 5 years $ 64,993
Present value of $9,000 received annually for 5 years 35,007
Market price of bonds $ 100,000 double underline
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Do It! 2: Bond Terminology
Indicate whether each of the following statements is true or false.
Secured bonds have specific assets of the issuer pledged as collateral.
True
Callable bonds can be redeemed by the issuing company at a stated dollar amount prior to maturity.
True
The contractual interest rate is the rate investors demand for loaning funds.
False
The face value is the amount of principal the issuing company must pay at the maturity date.
True
The market price of a bond is equal to its maturity value.
False
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L O 3: Explain How to Account for Bond Transactions
A corporation records bond transactions when it
issues (sells) or redeems (buys back) bonds and
when bondholders convert bonds into common stock.
Bonds may be issued at
face value,
below face value (discount), or
above face value (premium).
Bond prices are quoted as a percentage of face value.
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Issuing Bonds (1 of 2)
Review Question
The market interest rate:
a. is the contractual interest rate used to determine the amount of cash interest paid by the borrower.
b. is listed in the bond indenture.
c. is the rate investors demand for loaning funds.
d. More than one of the above is true.
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Issuing Bonds (2 of 2)
Review Question
The market interest rate:
a. is the contractual interest rate used to determine the amount of cash interest paid by the borrower.
b. is listed in the bond indenture.
c. is the rate investors demand for loaning funds.
d. More than one of the above is true.
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Issuing Bonds at Face Value (1 of 2)
Illustration: Devor Corporation issues 100, five-year, 10%, $1,000 bonds dated January 1, 2017, at 100 (100% of face value). The entry to record the sale is:
Jan. 1
Cash
100,000
Bonds Payable
100,000
Prepare the entry Devor would make to accrue interest on December 31.
Dec. 31
Interest Expense
10,000
Interest Payable
10,000
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Issuing Bonds at Face Value (2 of 2)
Prepare the entry Devor would make to pay the interest on Jan. 1, 2018.
Jan. 1
Interest Payable
10,000
Cash
10,000
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Discount or Premium on Bonds (1 of 3)
Issue at Par, Discount, or Premium?
▼ Helpful Hint
Bond prices vary inversely with changes in the market interest rate. As market interest rates decline, bond prices increase. When a bond is issued, if the market interest rate is below the contractual rate, the bond price is higher than the face value.
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Discount or Premium on Bonds (2 of 3)
Review Question
Laurel Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:
a. the contractual interest rate exceeds the market interest rate.
b. the market interest rate exceeds the contractual interest rate.
c. the contractual interest rate and the market interest rate are the same.
d. no relationship exists between the two rates.
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Discount or Premium on Bonds (3 of 3)
Review Question
Laurel Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that:
a. the contractual interest rate exceeds the market interest rate.
b. the market interest rate exceeds the contractual interest rate.
c. the contractual interest rate and the market interest rate are the same.
d. no relationship exists between the two rates.
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Issuing Bonds at a Discount (1 of 2)
Illustration: Assume that on January 1, 2017, Candlestick Inc. sells $100,000, five-year, 10% bonds at 98 (98% of face value) with interest payable on January 1. The entry to record the issuance is:
Jan. 1
Cash
98,000
Discount on Bonds Payable
2,000
Bonds Payable
100,000
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Issuing Bonds at a Discount (2 of 2)
Statement Presentation
Sale of bonds below face value causes the total cost of borrowing to be more than the bond interest paid.
The issuing corporation not only must pay the contractual interest rate over the term of the bonds but also must pay the face value (rather than the issuance price) at maturity.
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Total Cost of Borrowing (1 of 2)
Bonds Issued at a Discount
Annual interest payments Blank
($100,000 × 10% = $10,000; $10,000 × 5) $50,000
Add: Bond discount ($100,000 − $98,000) 2,000
Total cost of borrowing $52,000 double underline
Bonds Issued at a Discount
Principal at maturity $100,000
Annual interest payments ($10,000 × 5) 50,000
Cash to be paid to bondholders 150,000
Less: Cash received from bondholders 98,000
Total cost of borrowing $52,000 double underline
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Issuing Bonds at a Discount
Amortization of bond discount:
Allocated to expense in each period.
Increases the amount of interest expense reported each period.
Amount of interest expense reported each period will exceed the contractual amount paid.
As the discount is amortized, its balance declines.
The carrying value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount.
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Issuing Bonds at a Premium (1 of 2)
Illustration: Assume that the Candlestick Inc. bonds previously described sell at 102 rather than at 98. The entry to record the sale is:
Jan. 1
Cash
102,000
Bonds Payable
100,000
Premium on Bonds Payable
2,000
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Issuing Bonds at a Premium (2 of 2)
Statement Presentation
Sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid.
The borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the bond premium is considered to be a reduction in the cost of borrowing.
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Total Cost of Borrowing (2 of 2)
Bonds Issued at a Premium
Annual interest payments Blank
($100,000 × 10% = $10,000; $10,000 × 5) $50,000
Less: Bond premium ($102,000 − $100,000) 2,000
Total cost of borrowing $48,000 double underline
Bonds Issued at a Premium
Principal at maturity $100,000
Annual interest payments ($10,000 × 5) 50,000
Cash to be paid to bondholders 150,000
Less: Cash received from bondholders 102,000
Total cost of borrowing $48,000 double underline
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Issuing Bonds at a Premium
Amortization of bond premium:
Allocated to expense in each period.
Decreases the amount of interest expense reported each period.
Amount of interest expense reported each period will be less than the contractual amount paid.
As the premium is amortized, its balance declines.
The carrying value of the bonds will decrease, until at maturity the carrying value of the bonds equals their face amount.
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Do It! 3a: Bond Issuance
Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.
(a)
Cash
189,000
Discount on Bonds Payable
11,000
Bonds Payable
200,000
(b)
Long-term liabilities
Bonds payable
$200,000
Less: Discount on bonds payable
$189,000
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Redeeming Bonds at Maturity
Candlestick records the redemption of its bonds at maturity as follows:
Bonds Payable
100,000
Cash
100,000
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Redeeming Bonds before Maturity (1 of 2)
When a company retires bonds before maturity, it is necessary to:
eliminate the carrying value of the bonds at the redemption date;
record the cash paid; and
recognize the gain or loss on redemption.
The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date.
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Redeeming Bonds before Maturity (2 of 2)
Illustration: Assume at the end of the fourth period, Candlestick Inc., having sold its bonds at a premium, retires the bonds at 103 after paying the annual interest. Assume that the carrying value of the bonds at the redemption date is $100,400 (principal $100,000 and premium $400). Candlestick records the redemption at the end of the fourth interest period (January 1, 2021) as:
Jan. 1